Preventing the new mediocre from becoming the new reality: The role of fiscal policy

Bernardin Akitoby, Sanjeev Gupta, Abdelhak Senhadji18 July 2015

There has been a heated debate about the effectiveness of fiscal policy as a countercyclical tool but little evidence on how it can support growth. This column shows that fiscal policy can lift medium- and long-term growth in both advanced and developing economies. But all fiscal reforms are not equal in their growth dividend. Successful reforms are often part of a broader reform package and can balance the growth-equity trade-off.

Estimates of potential output continue to be revised downward, reminding policymakers of the risk of a ‘new mediocre’—low growth for a long time (IMF 2015a). But how can policymakers prevent the 'new mediocre' from becoming the ‘new reality’? With little room left on the monetary policy side, can fiscal policy lift potential growth? There has been a heated debate about the effectiveness of fiscal policy as a countercyclical tool, but there is little evidence on how fiscal policy can support medium- to long-term growth. A recent IMF study attempts to fill that gap (IMF 2015b).

Drawing on diverse country studies and the Fund’s unique perspective gained from providing hands-on advice on fiscal reforms to a wide membership, this column presents multi-pronged evidence that fiscal policy can help economies around the world escape the new mediocre. Our four key findings are:

Fiscal reforms can lift medium- to long-term growth;

All fiscal reforms are not equal in their growth dividend;

Successful fiscal reforms are often part of broader reform packages; and

The growth dividend from fiscal reforms can be substantial

While it is difficult to disentangle the impact of fiscal reforms from other factors, we find strong evidence that the medium- to long-term growth dividend of fiscal reforms is larger than previously thought. Using the Synthetic Control Method (SCM) to assess the impact of fiscal reforms on growth, country studies show a significant increase in average growth during the ten years following fiscal reform episodes (Figure 1A).1 In advanced countries, per capita growth in the post-reform period is about ¾ percentage points higher than the counterfactual. In developing economies, the growth dividend reaches almost 2½ percentage points on average. An important question is whether fiscal policy boosts growth through factor accumulation or total factor productivity. The relative importance of these channels differs across income groups. While advanced economies experienced relatively balanced contributions, in emerging markets and low-income countries (LICs), capital accumulation was the dominant source of growth (Figure 1B).

Source: IMF staff calculations.1/ 5-year averages for Germany and Poland.2/ Chile (1) refers to the first reform episode (1974); Chile (2) to the second reform episode (1983); Australia (1) to the first reform episode (1985); and Australia (2) to the second reform episode (1998).

All fiscal reforms are not equal

After investigating 146 episodes of growth accelerations in 112 countries, we find that revenue reforms are most likely to be followed by growth acceleration in emerging market and low-income countries, while spending reforms in advanced economies are more promising.2 This reflects the need to rationalise spending in advanced economies and mobilise revenue to finance development in emerging market and low-income countries. Furthermore, the likelihood of growth acceleration depends on the fiscal instrument (Figure 2).

Successful fiscal reforms are often part of broader reform packages

In all countries studied, fiscal measures reinforce each other. For example, in the Netherlands, Ireland, and Germany, work incentives were enhanced by reducing benefits and income taxes. Other countries simultaneously reduced corporate/personal income taxes and current spending in order to stimulate private investment and employment (Poland, Australia, Ireland, Netherlands, Chile, and Malaysia). In Tanzania, the scaling up of public investment was preceded by improvements in public financial management. Our analysis of growth acceleration episodes confirms the potential benefits of policy complementarities; the likelihood of growth acceleration is higher when expenditure and revenue reforms are carefully combined to exploit synergies and complementarities.

Supportive structural reforms in other areas;

Broader structural reforms can help boost medium- to long-term growth and magnify the impact of fiscal reforms. In the majority of the country studies, fiscal reforms were accompanied by other structural reforms. To boost employment, countries combined strengthened work incentives with labour market reforms aimed at facilitating job creation, such as streamlined hiring/firing procedures, changes in wage bargaining, and minimum wage cuts (Netherlands, Ireland, and Germany). In other cases, fiscal consolidation to create room for corporate tax reductions was pursued simultaneously with economic deregulation and privatisation (the Netherlands, Malaysia, and Chile). In Tanzania, opening up the economy, including through trade liberalisation, helped enhance the effectiveness of fiscal reforms and create a favourable environment for private-sector development.

Well-designed fiscal reforms can balance growth-equity trade-offs

Some reforms that increase efficiency have adverse distributional consequences. For instance, a shift from direct to indirect taxes, aimed at reducing distortions and promoting growth, can reduce the progressivity of the tax system and increase inequality. A reduction in social transfers—to encourage labour participation—might likewise worsen equity. In the country studies, inequality increased especially where current spending cuts involved reductions in social benefits (Figure 3). In Australia, income inequality widened in part because the reforms in the 1980s increased wage dispersion, and the introduction of the GST in the early 2000s reduced the progressivity of the tax system (Singh et al. 1998, Greenville et al. 2013).

Appropriately designed fiscal reform packages can serve both growth and equity objectives.[3] For example, if the proceeds of a regressive, yet growth-enhancing tax reform are used to finance higher health and education spending, the overall outcome may be higher growth and lower inequality (Clements et al. 2014). After Ireland’s first reform episode in the late 1980s, income inequality did not increase significantly despite a sharp reduction in public spending. This reflects the composition of fiscal adjustment – specifically the fact that cuts in public sector wages and untargeted transfers turned out to be progressive—and the sharp increase in employment subsequent to reforms (Bastagli et al. 2012).

In Malaysia, spending to reduce ethnic inequality was protected when a 10% of GDP cut in primary spending was instituted during the second half of the 1980s. Measures that helped reduce inequality and poverty included the public provision of health and education services, particularly in rural areas; a system of targeted transfers; and education and technical training to facilitate mobility from agriculture to higher-value added activities.

Conclusion

Fiscal policy can lift medium- to long-term growth by ¾ of a percentage point in advanced economies and even more in developing economies. The particular mix of policy measures, however, will depend on country-specific conditions, capacities, and preferences. Design matters for the success and durability of fiscal reforms. They need to be internally consistent and complemented by relevant structural reforms. The growth-equity trade-offs can be handled by good design and social dialogue.